Navigating the Small Business Financing Landscape
In the past decade alternative small business (SMB) lending has grown rapidly as banks retreated from the asset class. The aftermath of the 2007–2008 recession forced banks and other established financial institutions to scale back SMB lending as regulations, consolidation of regional banks, portfolio defaults and their own cost structure made the risk / return of smaller loans unattractive.
In the banks’ place emerged a new crop of alternative lenders serving small businesses. Debt and equity capital flooded in to back them, propelled by a historically low rate environment. These alternative lenders originated and underwrote almost completely online. They touted their technology, underwriting models and capitalization (marketplace for some) as differentiators. They claimed that their lack of physical locations reduced their overhead, allowing them to earn profits on smaller loans than banks could. They all said they were fast, some underwriting in less than a day. These platforms arrived to great fanfare and were well covered by the tech and business press. In addition, they wrote their own articles and commissioned research as they fired up their marketing engines.
This is all great, except an online search can leave a small business owner completely bewildered. The amount of information floating around now makes it very difficult to separate signal from noise when searching for the right financing. Just getting a comparable interest rate between two types of loan products is a challenge.
Wharton FinTech will attempt to outline the most common financing options available to small businesses in addition to providing their backstory. In order to do so, we’ll segment the market between shorter and longer term products.
TLDR? Check out the tables below that provide side-by-side comparisons. Note that the variety of financing products available to small businesses today has increased dramatically in the past 10 years. This article is not meant to be an exhaustive list by any means, but rather to provide background and comparability on some of the most popular options.
Shorter Term Financing (<18 months)
We categorize shorter term financing products as those with an expected term of less than 18 months. They are typically underwritten quickly, paid back rapidly and best used for working capital or emergencies.
Their fees when extrapolated into effective Annual Percentage Rates (APRs), by running IRR calculations on the cash flow repayments, range from fair to extremely high. Many of the lenders that offer them will tell you that effective APR is a poor method of calculating true cost. However, for borrowers it’s useful to have an “apples to apples” metric to compare products.
It’s important to note that APR is one variable of several to consider. Other factors include lender reputation, term, speed, customer service, penalties, other fees and collateral requirements.
Merchant Cash Advances (MCAs) are short term advances paid back as a percentage of revenue, with daily payments. The product began in the early 2000’s as credit card processors realized they could lend against their business customer’s daily credit card receivables. The product increased in popularity during the early 2000’s and has culminated in a public company (OnDeck) and many private competitors generating several billion dollars in annual volume. The introduction of MCAs that use ACH to debit repayments from bank accounts has made the product viable for merchants that rely on sales outside of credit cards.
MCAs are repaid based on a multiple of the money advanced to you. Take for example a $100,000 advance with a 1.2x factor rate and a 15% split of credit card receivables paid daily. This example requires the merchant to pay back $120,000 using 15% of their credit card sales every day. The payback time is triangulated to be between 6 -18 months based on historical sales and seasonality, though they’re usually paid back in less than a year.
The ACH debit version of the product draws a fixed daily amount from a merchant’s bank account until the advance and the factor fee amount is repaid. MCA APRs can range from ~30% to 100%+. Their short duration and rapid repayment limits the exposure of the lender but elevates APRs. Check out this article for a more detailed analysis of true MCA rates.
A few things to note about MCAs. (i) They’re legally not a loan but a sale of future receivables. As such, they won’t help build business credit. (ii) MCA providers are underwriting your top line sales, so it’s easier for asset-light or unprofitable businesses to be approved. (iii) They are best used by B2C businesses with healthy daily sales volume (restaurants, salons, etc) for short term funding needs. The product is frequently used for business loans when the owners have bad credit.
Two notable entrants into MCAs over the past few years are payment processors PayPal and Square. Their entry was a logical step as they control the payment channels and hold a wealth of data on their merchants. The expansion has been resoundingly successful for both companies. In 2015, Square Capital and PayPal Working Capital originated over $400 million and $900 million, respectively. Both are now among the top 10 largest MCA originators in the world.
Note, Square recently announced that they would no longer be offering a pure MCA product. Instead, through a partnership with a bank, they are now offering a unique loan product that has a fixed term of 18 month but is still repaid with a split of credit card sales. Analysis on why they made the switch can be found here.
Receivables Financing (Factoring, ABLs, Dynamic Discounting, PO Financing) is the purchase of or lending against commercial paper, invoices, receivables, trade acceptances and contract rights. It’s an ancient form of financing, with the earliest recorded mention in the Code of Hammurabi in 1754 B.C. There are many related versions of receivables financing but the most commonly used by small businesses are outlined below.
Factoring is used by B2B companies that have cash outflows before they receive the necessary customer payments to cover them. Often these companies have growing A/R balances driven by increasing revenue and/or customers with extended payment terms. It’s very popular in the textiles, trucking, wholesale and staffing industries. For non-spot factoring, borrowers are given a credit limit that they can draw against with eligible invoices.
To illustrate, let’s highlight an example using simple numbers. The factoring company (factor) will purchase a $10,000 invoice and pay the borrower 80% of the invoice amount (advance), holding back the remaining 20% (reserve) until the invoice is paid. The factor has legal ownership of the invoice and will usually have the invoice payment sent to them. Once the invoice payment has been received, the factor will release the reserve to the borrower, net of their factoring fee.
Fees in invoice factoring typically range from 1–6% per month, with advance rates ranging from 70–90%. There is wide variation in pricing and advance rates depending on the creditworthiness of the borrower’s customers, the creditworthiness of the borrower, their industry and sales volume. Factoring fees extrapolated into APRs range from mid-teens to 50%+. However, it’s worth noting that these are very short term transactions, typically 30–90 days, so the actual percentage fee is much lower than the extrapolated APR.
The product is a useful tool for businesses with healthy gross margins to manage their cash flow because the underwriting focuses primarily on the borrower’s customers. Thus a startup serving large customers can often receive a more favorable rate using factoring than from other financial products based on its own creditworthiness. Wharton startup Harper focuses on receivables financing for digital media, advertising and technology companies.
ABL Credit Lines (ABLs) are a form of asset-based lending that is a cousin to factoring. There are many variations of ABLs but generally the lender provides a line of credit that is based on an eligible borrowing base comprised of receivables and inventory. Interest is charged on daily or average monthly outstanding balances. The lender does not take ownership of the receivables or reroute the payments like in factoring (pure invoice financing versions of ABLs are sometimes called invoice discounting lines). This type of product is very lender and industry-specific so there is wide variability in eligible assets, interest rates and advance rates.
The lender will still take a lien on the business’ assets, but the borrower owns and collects on their invoices. ABL credit lines require more stringent underwriting of the borrower than factoring because the receivables are owned and collected by the borrower. As such, less businesses will qualify for this form of financing than factoring.
Dynamic Discounting is a unique form of supply chain financing where suppliers and buyers match early pay discounts dynamically. Several VC-backed startups are building platforms allowing large buyers and their suppliers to submit “bids” in order to reach a market clearing early payment discount.
Buyers earn discounts on early payment and suppliers get paid early (think a fluid version of the classic 2 /10 net 30). The supplier is willing to take a discount for early payment because it boosts cash flow and usually is a lower rate than they could obtain from other working capital financing sources. Meanwhile, the buyer earns a discount on its payables at a rate higher than its cost of capital. The ease of use and potential cost of capital arbitrage make these platforms attractive to both parties. However, buyers must be integrated on the platform in order for their suppliers to use this form of financing.
Wharton and Y Combinator startup Tesorio is focused on building a platform in this space to help suppliers get paid faster.
Many other lending products (PO financing, revenue backed lines, hybrid products) exist that are backed by a combination of future sales, receivables, inventory and even monthly contracted revenue. Examples of lenders providing unique products include Lighter Capital that finances SAAS companies by lending against contracted monthly recurring revenue (MRR); Kabbage that provides a hybrid MCA / short term loan product paid back on a fixed schedule; and Fundbox that funds chosen invoices and is repaid in 12 equal weekly payments.
Another unique form of receivables financing we should mention is purchase order (PO) financing. It is used to pay suppliers for large orders that companies can’t fund themselves. This financing is only available to companies selling physical goods (service providers should look into contract financing), buying finished products from their suppliers and that have 20%+ gross margins.
Longer Term Financing (>18 months)
Longer term financing products more closely resemble the classic definition of a “loan”. They generally take longer to underwrite than shorter term products but are also less expensive. Longer term products usually require some form of asset collateral, or in the case of venture debt, VC equity cushion and some form of equity sweetener.
Term Loans are financial products with terms ranging from 1–5 years. They resemble what you imagine a traditional small business loan to be. They’re paid back over their duration in installments and carry relatively low fixed interest rates compared to other products (5–30%). They require a lien on all business assets and personal guaranty. As long as you make your payments on time, they can help improve your business credit.
They are offered by both online lenders and banks. Online lenders will typically require at least $150,000 in revenue, 1 year in business (preferably 2), at least a year of profitability and can lend up to $500,000. Banks have more stringent requirements but can lend several million dollars depending on how creditworthy they judge your business to be.
Term loans should be used for high ROI capital investments and expansion that easily justifies their interest rate.
SBA Loans are also term loans, except that they are originated by certain banks as part of a program backed by the Small Business Administration (SBA). Because the banks aren’t on the hook for the entire loss if the borrower defaults, they’re able to offer much lower rates compared to other options available to SMBs. SBA loans can range in size from less than $25,000 up to $5 million.
Applying for an SBA loan, however, can take months and despite the government’s backing, there’s still no guarantee of approval. The loans also typically require collateral (real estate, equipment, AR, and in some cases, inventory), though lack of it will not be the only reason the bank declines an applicant. SBA loan applications also require a fair amount of paperwork.
Both fixed and variable interest rate terms are available. Rates range from 3.37% for real estate loans up to 8.25% for general purpose loans. Here’s more detail on current SBA program interest rates and terms and a list of the top 100 SBA banks.
Equipment Financing can be used to purchase most types of business equipment and can involve a lease or a loan. With a loan you may be asked to put down a certain percentage of the equipment cost upfront. Depending on your credit history, your lender may even file a blanket lien against your business or property in order to secure their funds. Further, you’ll go through the normal loan underwriting process.
An equipment lease on the other hand generally requires no down payment, extra collateral or a blanket lien. The process to apply for a lease is usually easier than it is for a loan. Depending on the value of the equipment, you may be able to get approved for a lease within 24 hours. Most lease agreements include an option to purchase the equipment after the lease term is over.
The rates for this product are usually fixed and range from 8–35%+. The term is often the useful life of the equipment. Equipment sellers will frequently have financing programs available either through a captive financing arm or preferred third party financing partners.
Venture Debt is a form of debt financing for VC-backed companies that lack the assets or cash flow for traditional debt financing, or that want greater flexibility. Venture debt is provided by banks or dedicated funds as a complement to equity financing. It’s usually used to extend the runway of a startup and / or serve as bridge financing during a tough period in order to avoid a down round. It’s useful for many startups because it’s less dilutive than equity and usually has little to no corporate governance requirements (board seats).
Venture debt is usually floating rate and priced at the prime rate +0% to 10% depending on whether the lender is a bank or a fund. Typical terms are 3–4 years and require equity warrants or shares that give the lender some upside in the company. Equity dilution from the exercised warrants are usually ~1% — significantly less than raising another round of equity.
Bessemer Venture Partners provides good overview materials to learn more about this form of financing.
Many thanks to Jeff Ellington of Dorm Room Fund, Brian Anderson and Matthew Applegate.
